How the SEC Could Pursue Case Against JPMorgan

JPMorgan Chase's failure to timely disclose a major change in how it measured risk could become the centerpiece for an enforcement action by U.S. securities regulators as they probe the bank in connection with its multibillion dollar trading loss.

By omitting the change from its earnings release in April, the bank disguised a spike in the riskiness of a particular trading portfolio by cutting in half its value-at-risk number.

JPMorgan did not tell investors that the model for its Chief Investment Office had been changed until May 10, the same day it revealed the failed hedging strategy had produced a loss of at least $2 billion.

Securities and Exchange Commission Chairman Mary Schapiro said last month that her agency is probing the bank's financial reporting and made a vague reference to banks' obligation to publicly disclose changes to their risk model.

Experts say that regulators' strongest potential case is one focusing on whether JPMorgan should have disclosed the risk model change earlier.

But at the same time, they say it may be difficult to prove that the change in the risk model was material to shareholders' interests, which could limit the SEC's ability to use the JPMorgan investigation to appear tough on big banks playing fast and loose after the financial crisis.

"I would think this is a case that gets down to questions about just how aggressive the SEC wants to be," said Jim Cox, a professor at the Duke University School of Law.

JPMorgan chief Jamie Dimon, 56, is expected to be questioned over the change in the risk model on Wednesday when he is called before the Senate Banking Committee to testify.

Dimon has not said exactly when or why the model was changed, nor has he said who knew about it. He has said that the portfolio not only took on too much risk, but "was badly monitored."

Typically, changes in value-at-risk models at banks are made by committees composed of managers who monitor risks and business heads who take them, according to risk management experts.

Kristin Lemkau, a spokeswoman for JPMorgan, declined to comment.

MATERIALITY QUESTION

Banks in the United States are required to give investors periodic counts of their value-at-risk. The numbers are calculated and presented differently across companies, but in general are supposed to show a minimum amount that a portfolio could be expected to lose in each of a few days during a quarter.

What's most useful to investors is not so much the actual numbers, but how much they change, experts say.

JPMorgan first told investors on April 13 that the reading of risk at its CIO unit as of the end of March showed that the unit could lose at least $67 million in a single trading day, slightly less than the $69 million from the previous reading in December.

The report indicated steady risk management in the CIO's office, which was in contrast to press reports at the time that a London-based trader for JPMorgan was taking whale-sized positions.

But on May 10 when the bank suddenly disclosed the $2 billion-plus loss, it also revealed for the first time that the $67 million reading had been calculated with a new model. The prior model showed risk had actually spiked as the value-at-risk nearly doubled to $129 million.

Had the higher number been reported, said analyst Jason Goldberg of Barclays, "certainly, they would have been asked why the VaR doubled."

To bring a potential case against JPMorgan over its value-at-risk model change, the SEC will need to decide if the failure to disclose the model change was "material." In other words, would a reasonable investor see the information as significant?

Experts are divided on whether the understatement of risk by the bank will meet the SEC's legal test. It is unclear if investors would have seen the hike in risk-taking as something that could lead to a big trading loss.

"It may look bad and it may smell rotten, but it is not obvious that switch would have greatly misled the market or greatly influenced the stock price," said Lawrence Cunningham, a law professor at George Washington University. "That is a materiality question."

But some experts say that the threshold for materiality of risk-taking is lower in current market conditions.

Elizabeth Nowicki, a professor at Tulane University Law School, said the failure by the bank to timely tell investors about changes to its risk valuation methodologies is significant - especially because investors are still spooked by the financial crisis of 2008.

"When disclosure was a huge, huge issue leading to the debacle of 2008, it is important to the SEC to show no mercy on the issues of disclosure in the financial industry," said Nowicki.

JPMorgan and Dimon have a legal powerhouse to argue the understatement was not significant. The team includes two former SEC enforcement directors: Stephen Cutler, the bank's general counsel, and William McLucas, a partner at Wilmer Hale Pickering Hale and Dorr LLP who has been retained in connection with the trading loss.

INTERNAL CONTROLS?

Since the financial crisis, the SEC has faced a barrage of criticism for what some say is a failure to go after the top executives at the country's major banks.

Several legal experts say that the failure of JPMorgan to disclose changes to its value-at-risk modeling could actually present a prime opportunity to do just that.

The SEC could investigate whether the episode reveals failures by Dimon and Chief Financial Officer Doug Braunstein to adequately control the bank's internal financial reporting and disclosure procedures to investors.

Even if the SEC did not charge executives under internal control provisions, digging into the area could prove fruitful in other ways. It might turn up email chains that give insight into how the model was changed, and who at the company knew what.

It could also put pressure on the company and its executives to agree to settle and pay a fine.

"To make management sweat a little bit, the SEC's focus might well be on internal controls," said Charles Whitehead, a professor at Cornell Law School and former Wall Street executive.